“Is the estate plan will-based or trust-based?”
That was one question among many I faced from the children of a long-time client couple at a multigeneration family meeting on a brisk spring Saturday morning.
I paused to consider it.
The couple had created and were funding irrevocable spousal access trusts to protect assets from taxes and nursing home bills. Trusts were clearly playing a prominent role. Yet a will—not a revocable living trust—was still the main tool in place to transfer other assets, such as bank accounts, investment accounts, and their home.
“It’s will-based,” I said, after a bit of reflection.
Yet that didn’t seem quite right. I soon changed my tune.
“It’s a hybrid,” I said, thinking on my feet. “Some assets pass by trust and some pass by the will.”
As I spoke, I was looking at an impressive balance sheet the family had set up on a screen for the meeting in their living room. It reflected a lifetime of working hard at middle-class jobs, funding retirement plans, and raising and educating the children who, along with their spouses, were now asking these questions.
The result was that most of the couple’s assets—and nearly all of their financial assets—were in retirement plans. In this case, pre-tax IRAs.
“Actually,” I pivoted, “your parents have an IRA-based estate plan.”
There’s a good chance the same applies to you.
Manage, Preserve, and Transfer
Proper estate planning focuses on the management, preservation, and transfer of a person’s assets. It can come into play during a person’s lifetime if he or she becomes incapacitated. It is always activated by a death certificate.
Goals vary, but a near-universal objective is sending money to the desired people and institutions as quickly as possible, with as little court interference as possible, while minimizing professional expenses and taxes.
When teaching classes or talking to clients, I often start an estate planning discussion with a review of the four ways assets are transferred at death.
Own It Jointly
The first is by ownership.
Most people are familiar with this, especially if they are married. They typically own their bank accounts as joint tenants with rights of survivorship. The same often goes for their house.
In this case, if one person dies, the other owns the asset outright. There is no need to get an initial sign-off from a court or involve attorneys to transfer the asset.
Send It Directly
The second way is by contract.
This is less intuitive, but very powerful.
Trusts are contracts, and their terms detail how the assets they own will be managed and transferred. Because of their complexity and the inscrutability of legal language, they almost always involve attorneys both to set up and to administer at key points, such as when a grantor dies.
Privately held businesses may also transfer by contract, under the terms of a pre-established buy-sell agreement.
What often surprises people is that their largest assets may also transfer by contract, not by trust or will. The beneficiary forms that come standard on all retirement plans—and can easily be added to investment and bank accounts—act as transfer instructions by contract.
When a person dies, retirement assets, IRAs, money remaining in employer-sponsored plans, and non-qualified annuities pass to the people and institutions listed on the most recently filed beneficiary form.
These forms are free to file and update. They also don’t require the services of a separately paid professional, such as a lawyer or accountant, to execute during life or at death. And they move money completely outside the court-overseen process.
In most cases, the money will be transferred before probate is even open. All that is needed is a death certificate.
Transfer It Publicly and Formally
This brings us to your Last Will and Testament.
Your will transfers any remaining assets--in other words, only those assets that are not already owned jointly or transferred by contract.
This process will likely include hiring a lawyer and will always include a legal process overseen by the court. It is a public process.
Opinions on, and experiences with, the probate process vary.
I hosted a call-in radio show for a decade. Many attorney guests who liked trusts would speak eloquently about the virtues of minimizing probate with trusts. I also hosted probate judges who spoke to the fairness and structure of the process and warned that the privacy of trusts can make it easier for family members to misbehave without oversight.
Both views are likely correct.
Interestingly, I don’t recall anyone ever focusing on the virtues of beneficiary forms, perhaps because they don’t involve paying attorneys or showing up in probate court.
Prince’s Choice
The fourth way your assets can be transferred is by state law.
I call it Prince’s Choice because when the superstar died in 2016, he famously didn’t have a will. This meant that all his assets that were not jointly owned, held in trust, or attached to a beneficiary form transferred under the law of the state in which they were located.
We all have a default will. It is created by our state legislature and administered by our probate court.
So this is really just a less customized way of transferring assets by will.
Prince may have chosen it. Who knows?
I do have some clients who are fine with the state will and elect not to go through the expense and hassle of creating and executing their own will.
IRAs Are Different
Let’s return to IRAs and why it struck me that this family’s estate plan—a big part of mine and perhaps yours—is IRA-based.
IRAs transfer by contract, which is among my two favorite ways for assets to transfer. Furthermore, the actual contract—the beneficiary form—costs nothing to execute and adjust. These are the pluses.
The frustrations with IRAs, and why they are different from a bank account with a payable-on-death designation or an investment account with a transfer-on-death designation, stem from their tax-deferred status.
The ownership of IRAs cannot be changed without exposing their contents to income taxation or, in the case of Roth IRAs, potentially damaging the tax-free status of future gains.
This prevents people from transferring them during life to trusts, which they may want to do to protect the money from nursing home costs or from estate or inheritance taxes at the federal or state level.
You can put your house in a trust. You can put your bank account in a trust. You can put your investment account in a trust.
You cannot put your IRA, Roth IRA, or employer-based retirement plan in a trust.
The Good Old Days
Prior to 2020, these negatives were partially offset by what was known as the Stretch IRA.
This slang term developed to describe the ability of an IRA beneficiary to create an inherited IRA and use his or her life expectancy from the IRS Single Life Expectancy Table to take small distributions over many years and keep the bulk of the IRA enjoying tax deferral.
This formed the basis of many middle-class estate plans. It could also go wrong, as I detailed in last month’s essay, The Estate Plan That Should Have Worked.
In 2020, Congress took this option away for most non-spouse beneficiaries. In general, inherited retirement plan assets—employer plans, IRAs, pre-tax accounts, and Roth accounts—must now be completely drained within ten years after the original owner’s death.
This can radically reduce the after-tax value of a large inheritance. It also upended standard middle-class estate planning, meaning estate planning for people under the federal estate tax threshold of $15 million in assets per person. (In some states that impose estate and inheritance tax, this figure is lower.)
Back to the Beginning
We can now return to my epiphany that many of us have IRA-based estate plans whether we want them or not.
In the case in question, we long ago recognized this and did something about it.
We could not transfer large amounts of IRA assets efficiently and protect them for heirs. But we could transfer them slowly.
There is no need to wait until age 73 or 75 to start taking IRA distributions and putting the after-tax money to use.
· I’m all about your spending it to fund your Go-Go Years.
Any excess funds can be transferred to trusts. In this case, we turned on distributions in the couple’s early sixties, set up trusts for each spouse and secondarily for the children, and used the funds to purchase life insurance.
Properly executed, a strategy like this can be tax-efficient while protecting assets from spend-down for long-term care.
This strategy can protect a set value—the face amount of the life insurance—for a spouse and other heirs. It is a good start, but often not a good place to finish.
Maximizing the value of your pre-tax IRAs requires that you understand, estimate, and integrate not only your expected income tax and estate tax rates, but also those of your heirs.
I address this issue in my My Three Sons essay.
In some cases, Roth IRA conversions can pay off big. In other cases—often in the same family—having the parents pay the taxes now can destroy substantial value.
Like most strategies that involve taxes, it is an individualized puzzle. The pieces must be put in place by skilled hands looking at not only the big picture, but also the small details.
To get the best results, families often need to broach a topic they prefer not to discuss: each member’s finances.
It’s not quite as uncomfortable as discussing sex, but it’s not far behind.
It can, however, pay off big for those of us with IRA-based estate plans. And our team can help you get the process started.